Microsoft asks Wall Street to have faith

Company unveils vision for unprofitable Internet, entertainment units

JohnLetzing

SAN FRANCISCO (MarketWatch) -- Microsoft Corp. asked Wall Street analysts Thursday to have faith in Internet and entertainment businesses that have so far been a drag on the company's profitability.

At Microsoft's annual analyst day in its home town of Redmond, Wash., company executives laid out a vision that acknowledges its core Windows software products face an uncertain future, while its nascent online services and entertainment and devices units still require heavy investments to pick up the slack.

"Clearly, it wasn't a good year this year" for the entertainment and devices unit, Microsoft chief financial officer Chris Liddell said, referring to the $1 billion charge incurred by the unit's Xbox video game business in fiscal 2007 due to a technical glitch. Liddell said that in addition, the online services unit "will be negative next year," as the company continues to invest in it for the long-term future.

For the fourth-quarter ended in June, Microsoft said last week its online services unit posted a widening loss of $239 million, compared to a loss of $187 million in the period a year earlier. The entertainment and devices unit, which includes the Xbox and Zune portable media player, reported a loss for the fourth quarter of $1.2 billion, compared to a $423 million loss a year earlier.

Reaction among analysts Friday to Microsoft executives' emphasis on the importance of still-unprofitable businesses was mixed.

Pacific Crest analyst Brendan Barnicle, who rates Microsoft
MSFT, -0.35%
shares sector perform, said in a note that he was taken aback. "While it was clear that Microsoft was entering these [online and entertainment] markets, it was surprising that Microsoft chose to make them such a focus of its analyst day and its growth. We are concerned that these new markets have considerably weaker margins than Microsoft's existing businesses," Barnicle said.

Microsoft Chief Executive Steve Ballmer on Thursday outlined some of the reasons those "existing" businesses cannot continue to be relied upon so heavily.

As Microsoft increases sales in emerging markets, for example, it cannot count on owning as much market share as it has gained in regions such as the U.S. and Europe, Ballmer said. The company will be unable to have Windows shipments match PC shipments in such lower-priced, higher-piracy markets, and will "continue to see relative to PC growth challenges in Windows revenue growth," Ballmer said.

But Bear Stearns analyst John DiFucci wondered in a note Friday if Microsoft is fully committed enough to the shift to an online future.

DiFucci noted executives' strong belief in what they call a "software plus services" model, which takes for granted consumers' desire to avoid placing all of their content and data online, but rather to keep some stored by traditional means in hard drives.

"We can't help but wonder if the categorization of these as distinct and separate, versus two factors that must be merged into one, is an indication of whether Microsoft can successfully address the legendary problem of the 'innovator's dilemma'," DiFucci said.

Buying their way in

On Thursday Liddell and Ballmer threw water on the notion that Microsoft will make a large, dramatic acquisition to quickly make up ground in the online services market. One such scenario pondered by analysts has been the potential purchase of Yahoo Inc.
YHOO
to team up against online search leader Google Inc.
GOOG, -0.04%

"Are there some big things out there that we could conceivably buy? Sure," Ballmer said, though he added that he and Liddell are "basically organic-minded guys" when it comes to growth.

Kevin Johnson, Microsoft's platform and services division president, noted that the company has 380 million "live IDs," or users that sign in for a Microsoft online service once every 30 days. "We've got a credible offering, we're in the game," Johnson said, though he noted the company could "do a better job routing [Internet] traffic" from its Web pages to search services.

Barnicle said he is concerned that "Microsoft still does not have a 'killer' application" that is keeping users on its services.

"Microsoft will need to develop some compelling content before it can truly leverage its Internet services platform," Barnicle said.

An Xbox, Zune-based future

Entertainment and devices unit president Robbie Bach on Thursday repeated the previous assertion that his unit will achieve profitability some time during Microsoft's current fiscal year. However, for the company, there is "still going to be the need to invest in that business," he cautioned.

Bach acknowledged there is some pressure to cut the price of the Xbox console, in order to create a higher-volume business.

He cautioned analysts that the company "can't rush it or go too slow," on price cuts, though they are a definite possibility.

In addition to the Xbox, the other high-profile product included in the unit is the Zune portable media player, positioned to compete with Apple Inc.'s popular iPod. Microsoft reported last week it has sold over 1 million Zunes, which were released to consumers last fall. New and potentially revamped models of the Zune are expected in the fall.

Bach noted that the Zune, which is compatible with the nascent Zune Marketplace online content store, will ultimately prove a significant factor in Microsoft's overall online services scheme.

McAdams Wright Ragen analyst Sid Parakh, who has a buy rating on Microsoft shares, sounded encouraged by the company's emphasis on online and entertainment for the future.

"Ballmer said that [Microsoft] would strive to become an online 'advertising powerhouse,' underscoring its commitment to pour resources into this business and become the 'second largest' in the space. We side with [Microsoft] on this focus given the large market opportunity the business represents," Parakh said in a note.

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